Are crypto assets being included in asset allocation by more and more institutions?

Amid the turmoil of 2020, many market "truths" have turned into myths. And many trusted investing quotes no longer make sense.

One question that has been bothering me for a long time is how many financial advisors still recommend a 60/40 portfolio balance between stocks and bonds. In theory, stocks give you growth, while bonds give you income and a cushion when stocks fall. If you want to preserve your capital during the investment process, then I tell you, this is the diversification strategy for you.

Diversification itself hasn't been tested much, but whether you subscribe to chaos theory or just enjoy a balanced approach to investing, diversification is a very good rule of thumb.

This is what we need to take into account when diversifying our investments.

Why diversify your investments?

The idea is that diversification spreads risk. A strategy that hurts one asset may be good for another, or at least not hurt it as much. An asset may have unique value drivers that make it perform differently. And holding positions in low-risk, highly liquid products allows investors to cover unexpected events and take advantage of other investment opportunities when they occur.

This has largely been true. What needs to be questioned is the assumption that diversification should be spread across stocks and bonds.

One of the main reasons to split a stock/bond allocation is to hedge risk. Traditionally, stocks and bonds move in opposite directions. In a bad economy, central banks cut interest rates to revive the economy. This pushes up bond prices, partially offsetting the decline in stocks, resulting in outperformance of unbalanced funds.

Since the 2008 crisis, this relationship has broken down. In fact, as shown in the chart below, over the past 20 years, stocks (represented by the S&P 500) have outperformed balanced funds (represented by the Vanguard Balanced Index) on a rolling annual basis.

Why is that? First, central banks no longer use interest rates as a recession-proof tool. While negative interest rates are possible, they are unlikely to revive the economy enough to reverse a stock market decline caused by a recession.

And, as we’ve seen this year, stocks can keep rising even when the economy is struggling. Stock valuations became disconnected from expected earnings some time ago, driven by lower interest rates and a flood of new money chasing assets.

So, as long as central banks maintain their current policies, there is no reason to think that stocks will fall significantly this year, or that bonds will rise. And it is hard to see how they can exit their current strategies without inflicting significant losses on borrowers, including governments. So where should we look to hedge?

Another reason to hold a portion of bonds in a portfolio is for guaranteed income. This has been superseded by record low interest rates. And as for the "safety" of holding government bonds, sovereign debt/GDP ratios are at historical highs. No one expects the US government to default - but this is more a matter of trust than financial principle. The sustainability of trust is perhaps another hypothesis to examine.

You've probably heard it before: Government bonds once offered interest without risk. Now they offer risk without interest.

So why do financial advisors still recommend a bond/stock balance?

Why hedge?

Another potential reason is to hedge against volatility. In theory, stocks are more volatile than bonds because their valuations depend on more variables, but in practice, bonds tend to be more volatile than stocks, as shown in this 30-day volatility chart of the TLT Long-Term Bond Index:

Therefore, the rationale for the 60/40 stock-bond split, whether as a source of income or as a hedge, no longer makes sense. Even adjusting the ratio does not achieve the actual purpose. Now the fundamental weaknesses of stocks and bonds overlap.

More importantly, there is no reason to expect things to go back to square one. Even without a divided government, it would be hard to enact enough fiscal expansion to keep the economy going. More likely, expansionary monetary policy will become the new normal. That would keep bond yields down, stock prices stable or rising, and deficits ballooning.

This raises the question: What should a portfolio be hedged against?

Traditional portfolios hedge against the business cycle. In years of economic growth, stocks do well, and in years of economic contraction, bonds step in. However, the business cycle no longer exists. The signals that interest rates used to send have been emptied out by central banks, which means that investment managers who still believe in the business cycle are acting blindly.

What is the biggest investment risk facing savers today?

It is currency devaluation. In the past, expansionary monetary policy counted on the resulting economic growth to absorb the new money supply. The numerator (GDP) and the denominator (the amount of money in circulation) grew together, so that each unit of money at least maintained its value. Now, new money is pouring into the economy just to keep it afloat, which keeps the numerator constant (or even falling) while the denominator rises sharply. Ultimately, the value of each unit of money is falling.

A depreciation in the monetary base hits the value of stocks and bonds in long-term portfolios. Savers are less wealthy in terms of purchasing power than they were before. So the 60/40 split doesn't actually help them.

In an environment where currency devaluation looks increasingly certain, a new type of portfolio hedging is necessary.

In this context, the ideal hedge is an asset that is immune to monetary policy and economic fluctuations, an asset that does not rely on earnings for valuation and whose supply cannot be manipulated.

Gold is one such asset. Bitcoin (BTC, +2.82%) is another compound currency with an even more inelastic supply.

This has been boldly stated by Paul Tudor Jones, Michael Thaler (CEO of MicroStrategy), Jack Dorsey (CEO of Square), and others who have included Bitcoin in their portfolios and Treasuries, betting on its future value as a hedge against depreciation. The idea is not new.

But it is baffling that most professional managers and advisors still recommend a bond/stock split when it no longer makes sense. The fundamentals have changed, yet most portfolios are still clinging to an outdated formula.

Now, I’m not recommending investing in Bitcoin itself (nothing in this article is investment advice). What I am saying is that in the face of this new reality, investors and advisors need to question old assumptions. They need to rethink what hedging means and what the risks to their clients are truly facing long term, or they would be irresponsible with their clients’ investment funds.

In uncertain times, it’s understandable that we cling to old rules. But with so much change these days, we’re used to seeking comfort in the familiar. Yet it’s when current strategies no longer make sense that we need to question our assumptions. Rarely in modern times has there been so much uncertainty about future progress as now. In these times, the role of professional investors and financial advisors is more critical than ever, as savers desperately need not only guidance but protection.

Therefore, it is increasingly necessary to rethink portfolio management strategies, even for conservative portfolios. If we don’t, it’s not just returns that are at risk.

Getting better

Genesis (DCG, CoinDesk’s parent company) has released its third-quarter digital asset market report, which shows significant growth in lending and trading volumes and highlights an interesting industry shift.

New loans of $5.2 billion more than doubled from $2.2 billion in Q2, with growth coming primarily from loans in ETH (ETH, +2.96%), cash, and altcoins — BTC’s share of outstanding loans fell from 51% to 41%. The number of unique institutional lenders in Q3 increased 47% from Q2.

Spot trading volume increased by about 14% from the second quarter, with a clear upward trend in electronic trading. The derivatives trading department's bilateral derivatives trading volume exceeded $1 billion in its first full quarter.

These figures outline two trends:

1) Institutional interest in crypto assets other than Bitcoin is growing, driven primarily by the yields offered by DeFi protocols. The liquidity of these assets is often insufficient, which prevents institutions from generating strong interest in them, but ongoing experiments in the field and on the part of investors suggest that innovative services and strategies will eventually emerge that can handle larger volumes with manageable risks.

2) Institutional investors continue to develop increasingly sophisticated crypto trading and investment strategies. This highlights that the crypto asset market is growing, which will bring more institutional funds, which in turn will incentivize institutions such as Genesis to further develop products and services. This virtuous cycle is driving the market to where it should be: a liquid and mature alternative asset market that will more broadly affect how professional investors allocate assets.

The report also revealed that Genesis is developing a suite of products and services designed to facilitate the flow of institutional funds into the crypto market and surrounding markets: lending APIs, allowing deposit aggregators to earn yields, capital introduction and fund management, and agency trading. These, together with the launch of custody services in the third quarter, will further consolidate its growing network of market investors and infrastructure participants.

This could be a sign of increasing consolidation in the crypto market: the emergence of one-stop shops designed to help clients with all aspects of crypto asset management. An often-cited barrier to crypto investing is the fragmented nature of the industry, and the relative complexity involved in taking positions in crypto assets. Clearing these barriers would make it easier for professional investors to enter the space, while access to liquidity could encourage some to invest significantly.

Genesis will not be the only driver, and we may see other well-known companies competing to increase their institutional-facing services. This may lead to a series of M&A activities, as well as more strategic hiring of talent from traditional markets. Either way, the industry will benefit from the experience and maturity of the market infrastructure.

Does anyone know what's going on?

This week will undoubtedly go down in history as one of the more surreal ones in terms of events driving the markets.

First off, Tuesday was the longest day I can remember. In fact, as of this writing, it feels like Tuesday hasn’t even ended yet.

Second, stocks seem to love uncertainty. Who knows?

Third, Bitcoin burst onto the scene at a chaotic moment, introducing election results and political uncertainty into the market.

Bitcoin’s performance this week cemented its place among the year’s best-performing currencies (XLM, +1.18%). But the S&P 500 is having a field day — soaring so far in November and accounting for the majority of its positive performance so far this year.

CHAIN ​​LINKS

Veteran investor Bill Miller, chief investment officer of Miller Value Partners, revealed in an interview with CNBC this week that half of his MVP1 hedge fund is invested in Bitcoin. Conclusion: Yet another investor has made inflation concerns public as one of the reasons why professional investors should pay attention to Bitcoin. It can also be seen from Miller's statement that the risk of Bitcoin going to zero is "lower than it has ever been." He is talking about asymmetric risk: the probability of Bitcoin going to zero (losing 100%) is much lower than the probability of it providing a return of 200% or more.

As if proof was needed that this Bitcoin rally is very different from the last time the price of Bitcoin exceeded $15,000 in 2017, Google searches for "Bitcoin" are surging. Conclusion: This means the hype is much more muted this time around (despite some hubris on crypto Twitter). It also suggests that fewer "newbies" are entering the market — the buyers driving up the price of Bitcoin don't need to Google, which means they're not just attracted by Bitcoin's performance.

Square had revenue of $1.63 billion in Q3 2020, and gross profit of $32 million from the Cash App Bitcoin service. Year-over-year growth of approximately 1,000% and 1,400%, respectively. Conclusion: Selling Bitcoin in the Cash App earns Square less than 2% profit. Very low margins compared to Square's overall business, which has much higher margins. But the strong growth suggests a significant increase in retail demand for Bitcoin, which can partially explain the growth in BTC addresses and of course the price momentum.

Fidelity Digital Assets (FDA) is hiring more than 20 engineers. The company said in a post that it is working to improve existing Bitcoin custody and execution services and build new products. In summary: This recruitment hints at their expansion plans for digital asset services, which can broaden the channels for institutional investors given the influence of the FDA platform.

This article does not focus too much on Ethereum (ETH), the native token of the Ethereum blockchain, because it lags behind Bitcoin in market capitalization, liquidity, derivatives, and number of on-chain transactions. However, its infrastructure is maturing, and it is undergoing major technological changes that will affect its value proposition. More importantly, it can serve as a good diversifier for crypto asset allocation in a portfolio. It has significantly outperformed Bitcoin so far this year (220%/117%).

Ethereum 2.0’s deposit contract has gone live, marking the “point of no return” for the network’s migration to a PoS blockchain designed to enhance scalability and reduce costs. The launch of ETH 2.0 is now set for December 1, if 16,384 validators deposit the equivalent of 524,288 ETH into the contract by then. Bottom line: The deposit contract allows deposits of 32 ETH on the new chain, it will offer up to 20% annualized returns, and will serve as a one-way bridge between the current chain and the new chain. Ethereum creator Vitalik Buterin has sent 3,200 emails in exchange for 100 deposit contracts.

Crypto asset platform FTX said they will launch a derivative based on deposited ETH (called "Beacon chain ether", or BETH), which can be used as a liquidation for Beacon ETH after withdrawals are enabled next year. Summary: This is just a hint of innovation, as new products and use cases emerge. It can also increase interest in staking ETH because it theoretically provides liquidity for those who participate and removes illiquidity barriers for some investors.

In October, as the enthusiasm for decentralized finance cooled, the income that miners get from processing transactions on the Ethereum blockchain fell by more than half, and transaction fees fell by more than 60%. Bottom line: The decline in fees may not be good news for miners, but it is good news for the Ethereum network because it shows that congestion is receding.

Disclaimer: This website has the final editing rights for all articles published on this website. All works on this website are original works of Bitcoin Home or reprinted from the Internet. The purpose of reprinting is to convey more information, which does not mean that this website agrees with its views and is responsible for its authenticity. Any disputes have nothing to do with this website. If there are any problems with the content, copyright and other issues of the works, please contact this website as soon as possible.